Netflix Beats Estimates Causing The Stock To Soar 9%

Netflix Is Spending To Grow

Let's look at the earnings of all the TFAANG names because they are the market leaders. It will be tough for the S&P 500 to make a new all-time high if the momentum growth stocks don’t rally. Netflix is the poster child for this segment because it has a high multiple and high cost growth, but also high subscriber growth. Spending for growth is working for them for now, but the bears are wondering if the firm will be able to raise prices enough to start earning enough profits to justify its valuation. The firm needs to do this while competing with Disney which will be launching its own monthly service. That’s the basics of the Netflix debate which happens every quarter. It’s a weird situation in that the debate never changes even after each quarter. The reason for that is because the market is always focused on subscriber growth in the near term, but bears think costs need to be focused on.

Netflix Beats Estimates & Issues Great Subscriber Guidance

Let’s also look at the latest numbers and then review some analysis of the stock. EPS was 64 cents which met expectations. The current EPS doesn’t matter much to the stock because the multiple is incredibly high whether it beats by a few pennies or doesn’t. The consensus forecast for 2019 is $4.29 which means the 2019 PE multiple is 78. Revenue was $3.7 billion which slightly beat estimates for $3.69 billion. As I mentioned, the stock trades on streaming adds. Net adds were 7.41 million which beat estimates for 6.5 million. That sent the stock up 9.19% on Tuesday. Domestic adds were 1.96 million which beat estimates for 1.48 million; international net adds were 5.46 million which beat estimates for 5.02 million. Free cash flow was negative $287 million as the firm reinvests its subscriber revenue back into new content.

The chart below gives a complete summary of the recent reports. As you can see, the total subscriber growth quarter over quarter can be inconsistent. The bad news is that sometimes Netflix is bullish, but results miss estimates. The good news is subscribers are up 50% from last year which shows how powerful the brand and the service are. The key differentiation Netflix has is the ability to pick great original content and match users with the shows they are most likely to binge watch. The ultimate goal is to have the collection of content be worth more than the cost. Getting users to pay for those differentiation points make Netflix a valuable business.

The guidance was the other aspect which pushed the stock up as the firm’s expectation for Q2 earnings is 79 cents which beat estimates for 65 cents. The forward guidance on revenues was $3.9 billion which beat estimates of $3.89 billion. The guidance on net adds was the best part as Netflix expects to add 6.2 million which was better than the expectation for 5.24 million.

One smart decision management is making is that Netflix isn’t moving into news. That could be politically polarizing and hurt the brand which is beloved. Another smart decision is to bundle its subscriptions with Sky, T-Mobile, Altice, and Comcast. This can upsell existing customers and encourage new potential customers to try to service.

Bull & Bear Case

The chart below is the bull case for Netflix. As you can see, the cost of revenue is declining. The chart aims to show that the more subscribers the firm has, the less content it will need to purchase per user. Falling cost of revenue means higher margins. The counterpoint to this is when the capitalized expenses stop providing revenue because users don’t care about old content, the margins will fall. Netflix has a content depreciation schedule that it relies on. Clearly, the firm has proven it has the skill and technology to pick shows which will be the most popular. However, if it keeps needing to invest incredible amounts of resources into keeping subscribers happy, the business model doesn’t work. This is why I think being a subscriber is an amazing deal, but owning the stock is a terrible deal. Usually, it makes sense to invest in firms with great products. On the other hand, selling $1 for 90 cents isn’t a sustainable model.

Even if the business model works for Netflix, the stock is expensive. As I mentioned, there is negative free cash flow and a 78 PE on 2019 earnings. The chart below shows the historical revenue and cost growth. The good news is content costs grew slower than revenues from 2013 to 2017. If you assume the firm can grow at double digits for the next 10 years and bring content costs under control, the stock is worth $173 according to Aswath Damodaran’s model. The bet on Netflix is whether it can get costs under control. If the bet was just on whether it could add new users, I would buy the stock because clearly it is great at picking shows that become hugely popular. The firm has $17.9 billion in off balance sheet debt because of high content costs. It has a net debt to EBITDA multiple of 41 and an enterprise value to EBITDA multiple of 319.

Takeaway

Netflix is one of the most interesting stocks because the bears have a great argument on why the market is mispricing the stock, yet it continues to defy the logic of worrying about the negative free cash flow as its share price keeps accelerating. The stock is up 75% year to date which is amazing. The support investors give the firm has powered its ascent. If it had to worry about costs, it wouldn’t have grown this fast. The valuation will start to matter when it runs out of growth. In a sense, growing too fast could be bad because it means there’s less room to grow in the future. When growth investors shirk the stock and value investors make up the shareholder base, the stock will fall dramatically. The other potential negative catalyst is rising interest rates since it has so much debt.

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